Last week the Reserve Bank of India (RBI), for the 11th time in 17 months, hiked the repo rate to 8 per cent in an effort to rein in inflation. Here's a look at what the repo rate is, how the RBI manages it to control inflation and how it could affect you.

Repo, the policy rate

Repo rate is the rate at which the banks borrow short-term funds from the RBI. It is a secured nature of borrowing similar to a loan against fixed deposits availed by individuals during emergencies. Until March ‘10, banks were able to borrow funds from RBI's repo window at 4.25 per cent, way below the current 8 per cent.

Banks are mandated to invest around a quarter of their overall deposit (and borrowings) inflows into government securities. Only the excess over the mandated investment in government securities can be used to borrow funds from repo window. Generally, this kind of borrowing is of last resort as banks' core borrowing has to come from more traditional sources such as deposits. However, liquidity (money availability) in the financial system has been scarce for quite some time given the paltry rates banks were offering depositors. Therefore, the repo window has been used extensively by banks during these times (tight liquidity scenario).

Interest rates

So how does repo rate affect the interest rates in the banking system? RBI raises repo rate to increase the overall cost of funds in the banking system. Higher costs will keep in check the demand for funds.

So as demand slows, demand pull inflation will also slow. In a tight liquidity scenario, repo rate acts as a base rate (or minimum rate) at which the banks can borrow funds. A rise of 3.75 per cent (from 4.25 per cent to 8 per cent) in minimum rate of borrowing will naturally increase the rates at which they have to borrow elsewhere.

For instance, if the availability of funds is scarce, and banks are not able to borrow at repo rate, they may have to increase the deposits rates upwards to attract depositors. From the time repo rate uptrend began, the deposit rates of banks have gone up by more than 2 per cent on various maturities. Hence, any rate hike in repo rate increases the probability of higher deposit rates, which is good news for depositors.

Impact on borrowers and investors

If you are already a borrower or are looking to borrow from a bank, then the rate hike could add to your costs. For instance, many banks have hiked the loans rates by more than 2.5 per cent over the last one year period which in turn would lead to higher instalments for borrowers. To put this in perspective, a hike of 2.5 per cent in interest rate on a 10 lakh-15 year loan would mean increase in EMI outgo of about Rs 1,600.

Ssectors such as automobiles, consumer durables and realty are the most vulnerable in the scenario where policy rate hikes push the interest rates. Rising rates would not only reduce the demand for these companies' products, they will also affect their earnings in terms of rising interest costs.

Rising rates would also impact companies with higher leverage. Besides, there is a possibility that more money gets allocated to debt than equities given the risk-return tradeoffs. This however will also mean good return opportunities for investors who prefer bank fixed deposits.

9Need any other investment-related help? Feel free to write in to us at

>younginvestor@thehindu.co.in )

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